In Business Valuation, Normal Matters

There are many valuation approaches and methods, but they all have one thing in common: Ultimately, the value of a business is derived from its ability to generate earnings in the future. Typically, the starting point for measuring a company's earning power is its financial statements and other documents that reflect historic financial performance. But often, these documents contain entries such as above-market owner compensation or nonrecurring expenses or income that can distort a company's true earning potential. For this reason, valuation experts often adjust a company's financial statements to provide a picture of its financial performance under normal conditions. This serves two purposes: to remove owner bias from the financial statements and to derive unbiased financial statements for valuation purposes.

A valuation expert might normalize a company's balance sheet by adjusting its assets and liabilities to fair market value or some other appropriate standard. A business, for example, might have used accelerated depreciation methods that distort the values of certain assets. If the company has fully depreciated a piece of equipment over five years, but its actual useful life is 10 years, a normalization adjustment may be necessary to reflect the assets true value.

What's the rationale behind this? Adjusted depreciation expense reflects a truer picture of economic reality. On the income statement, normalization adjustments may be appropriate to develop a more accurate earnings history.

Common areas for adjustment include:

It's not unusual for business owners to pay themselves above-market salaries and benefits for services they provide to the company. Adjusting owner compensation to reflect market rates for comparable positions provides a more accurate measure of value to a hypothetical buyer of the business.

Businesses select accounting methods for a variety of reasons including tax planning that don't necessarily reflect their actual financial performance. For example, many companies elect the last-in, first-out (LIFO) method of accounting for inventory because it can yield significant tax benefits. But the method can also understate a company's inventory and depress its earnings. A valuator might adjust the financial statements to reflect first-in, first-out (FIFO) inventory accounting to provide a more accurate valuation.

One-time income or expense items can distort earnings. So, in order to more accurately reflect a company's future potential, a valuator might eliminate from historical earnings a judgment or settlement paid or received by the business or a significant bad-debt expense. Of course, for some businesses, bad debts and litigation expenses are a normal part of doing business, so in that case an adjustment wouldn't be appropriate.

Whether a normalization adjustment is appropriate may depend on the valuation's purpose. If a minority interest in a business is being valued, for example, a valuator probably wouldn't adjust owner compensation, because a minority owner wouldn't have the power to change this expense. If a business is being valued for sale, on the other hand, it's often appropriate to adjust compensation downward to reflect the salaries a buyer would likely pay. Similar adjustments might also be appropriate in a divorce context to ensure that the nonowner spouse is treated fairly.

In addition, when valuing a business for sale, a valuator might adjust for synergistic benefits, such as economies of scale or for cost savings a buyer might enjoy after integrating the business into its own.

Failure to consider normalization adjustments or making inappropriate adjustments can lead to inaccurate valuations. Experienced valuation professionals are well equipped to identify normalization opportunities, determine whether adjustments are appropriate and incorporate them into their calculations.